Skip to main content
scott barlow

TMX Group Inc. signage is seen at the Toronto Stock Exchange (TSX) in this file photo.Pawel Dwulit/Bloomberg

The S&P/TSX composite index was in record territory Wednesday thanks to strong recent returns from the materials and energy sectors. The market as a whole remains expensive, however, and without a widespread surge in profit levels the new high could more reason for investor concern than celebration.

The first chart below shows the sector performance behind the benchmark's climb to new heights. Materials and energy stocks have led the way, generating remarkable 12-month simple returns of 66.3 per cent and 35 per cent, respectively.

As for individual stock performance, the returns within these two market segments are scarcely believable. In materials, Ivanhoe Mines Ltd. jumped more than 600 per cent from 55 cents to $4.14 and in the oil patch, Bonavista Energy Corp's stock price almost quadrupled from $1.20 to $4.65.

Profits in commodity sectors were abysmal in early 2016, so the upcoming earnings seasons should show substantial year-over-year improvement – the bar is set low. It is very important that this happens. The domestic equity market is extremely expensive in terms of price-to-earnings levels and there are only two ways to return to normal valuations. Either earnings increase significantly, or the stock prices have to decline.

The lower scatter chart is an updated version of one I presented in the "How to make profitable investment decisions in 2017" presentation. It shows the ability of P/E ratios to predict two-year future cumulative returns for the S&P/TSX composite during the past decade. Because interest rates have a strong effect on valuations – corporate earnings streams are worth more to investors when bond yields are low, so valuation levels should be higher – I have added the government of Canada 10-year bond yield to the benchmark P/E ratio so that results are more comparable over time.

(In the chart, these values were calculated for the end of every week in the past 10 years. For each value, I calculated the future two-year cumulative return for the S&P/TSX – these are the dots on the scatter chart.)

The trend line on the chart, intended as a rough guide as to what investors can expect, slopes sharply downward from left to right. This illustrates that equity returns decline as P/E ratios rise and performance is stronger as rate-adjusted P/Es fall.

As of Friday, the trailing P/E ratio for the S&P/TSX composite was 23.4 and the 10-year bond yield ratio was 1.75 per cent. This adds up to 25.15, well above the historical average of 21.2. Follow 25.15 located on the Y-axis to the trend line, and see where that point on trend line meets the X-axis. The performance history plotted on the chart suggests deeply negative market returns for Canadian equity investors in the next two years.

The chart emphasizes the current higher risk investment environment – it combines rising valuation ratios and bond yields – but I do not believe the next two years will be as dire as the chart suggests. Continually rising bond yields would present a significant hurdle for equities but expected profit growth should return P/E ratios into more attractive territory.

TSX top performers

CompanySymbol3Y Avg. Ann. Total Rtn.3M Return %
New Flyer Industries IncNFI-T61.89.0
Klondex Mines LtdKDX-T54.5-13.8
Endeavour Mining CorpEDV-T52.3-4.6
Ccl Industries Inc CCL.B-T51.310.3
Premium Brands Holdings CorpPBH-T50.66.3
Detour Gold CorpDGC-T41.1-35.6
Boyd Group Income FundBYD.UN-T41.0-0.4
Constellation Software IncCSU-T40.95.0
Asanko Gold IncAKG-T37.6-11.1
Milestone Apartments REITMST.UN-T36.515.0
Ivanhoe Mines Ltd-Cl AIVN-T36.395.4